Friday, April 27, 2018

"Water water everywhere, and not a drop to drink" - Rime of the Ancient Mariner (Gustave Doré woodcut)

In a recent paper, John Taylor rhapsodizes about bringing back the good ol' federal funds market:

I think the case can be made for such a framework. Peter Fisher ran the trading desk at the New York Fed for many years, and knows well how these markets work. His assessment is that such a framework would work, saying “we could get back and manage it with quantities; it’s not impossible. We could just re-engineer the system and go back to the way we were.” I spent time in the markets for federal funds watching how they operated in those days, and I wrote up an institutional description of how good experienced people traded in these markets, and I developed a model showing how the market worked.

The fed funds market is currently moribund, but just a few years ago it was buzzing with activity. Banks that didn't have enough reserves at the end of the day to meet requirements could go to the fed funds market and buy them from banks who had excess reserves, the price they negotiated referred to as the fed funds rate.

I disagree with John Taylor. Resuscitating the fed funds market is not a good idea. The fed funds market is no longer used because the Federal Reserve has stuffed the market with so many reserves that banks no longer need to buy them from other banks to meet their requirements. But this cornucopia is a good thing. Any effort to bring back the fed funds market would ruin it.

Let's set up an analogy. Imagine a country called Waterland that gets tons of rain and has plenty of lakes and rivers. Since everyone has immediate access to water, there is no market for the stuff. The price of water is zero. Say that the government establishes control over the waterways and rainfall. It decides to limit the amount of water that is available to the citizens of Waterland. In response to this artificially-imposed scarcity, a market develops in which citizens buy and sell water among each other.

Markets are great. They allow those with too little of something to trade with those who are good at conserving what they need, both sides improving their lot in life. But this particular market should never have existed in the first place. Water is plentiful in Waterland, and so it should be a free good, not a market-traded one. The entire apparatus that has been built around the exchanging of water—informed dealers, speculators, exchanges, warehouses, networks for transporting water to and from market, auditors and lawyers involved in verifying water transactions—represents a waste. By consuming resources in constructing and operating the market, other more important projects never see the light of day. If the absurd water scarcity were to be removed, the market for water would disappear, freeing up resources for more socially beneficial uses.

Reserves, like water in the previous example, should by all rights be free. The only effort the Fed incurs in introducing a new unit of reserves into circulation is a keystroke or two. This means that the Fed can provide a bunch of new reserves, say by conducting open market operations, without incurring any costs whatsoever. As the Fed continues to mouse-click new reserves into existence, the demand that each individual bank has for reserves will eventually be satiated. Once that point is reached not a single bank will need to bid for the reserves of another bank, and so there will be no activity in the market for reserves. The fed funds market is effectively dead, as is currently the case.

Taylor wants to bring back the fed funds market. But this would mean putting an artificial constraint on the amount of reserves that the Fed supplies, much like Waterland's frivolous constraint on water. Banks, their satiation for reserves now being replaced by an artificial hunger, would suddenly be willing to pay a fee to other banks in order to get their hands on some reserves.

A whole fed funds trading apparatus would re-emerge. Traders would have to be hired and trained to to fill newly-formed fed funds desks. Bank resources would be diverted away from other valuable projects towards plotting the best way to time outgoing payments, the idea being to reduce the need to hold reserves in order to lend them out in the fed funds market. The Fed itself would have to rehire Peter Fisher to run its open market desk. All of this would be an expensive investment of time and money, diverting resources from other more socially beneficial activities.

In calling for a return to the days of an active fed funds market, it is as if Taylor were advocating for an artificial constraint to Waterland's supply of water, solely because he admired the market for water that emerged. Never mind that the whole water trading apparatus, though wonderfully efficient, represents a massive missallocation of resources. Given that I'm pretty sure Taylor would not want to kickstart a water market in a hypothetical Waterland, I don't understand why he is so keen to reboot the fed funds market.

Sunday, April 15, 2018

Over on the message board we've been discussing the implications of central bank-issued digital currency, otherwise known as CBDC. One view is that a central bank digital currency would lead to increased financial instability, Bank of England governor Mark Carney being a vocal proponent of this idea. There are a lot of criticisms that can be leveled against central bank digital currency, but the Carney critique is the one that worries me the least. Let's see why.

First off, let's establish what we mean by digital currency. Imagine that a central bank has discovered a technology that allows it to create an exact digital replica of the banknote. Like banknotes, these digital tokens are anonymous and untraceable. To make use of them, people don't have to register for an account. Rather, the tokens are held independently on one's device, sort of like how paper money is held in one's wallet without requiring any sort of registration with the issuing central bank. This combination of features makes it impossible for the central bank to censor or prevent people from using digital currency, in the same way that the central bank can't stop people from trading paper money among themselves.

Unlike banknotes, which can only be passed face-to-face, digital currency can be transferred instantaneously over the internet. There are no storage and handling costs. $10 million dollars worth of $20 bills takes up a lot of space and is awkward to carry around, but in the digital world that same nominal amount has neither volume nor weight. Lastly, digital currency is cheap to create, requiring only a few keyboard strokes. Cash requires large printing machines, ink, and paper.

Having established what a digital currency is, let's introduce it into the economy. The central bank announces a demonetization of all banknotes and coins, offering $1 of digital currency for each $1 worth of cash. Anyone who want to withdraw money from their bank account will now get digital currency, not banknotes. No one visits ATMs or the bank teller anymore to make a deposit or withdrawal: with an internet-connected device, deposits and withdrawals can be made from bed, the toilet, or while commuting on the bus.

Carney's contention is that the introduction of a digital currency could hurt the banking system:

"...a general purpose CBDC could mean a much greater role for central banks in the financial system. Central banks may find themselves disintermediating commercial banks in normal times and running the risk of destabilising flights to quality in times of stress."

First, let's deal with Carney's normal times critique. The idea here is that by introducing a digital version of the banknote, a significant proportion of existing depositors—those with chequing and savings accounts—will desert their bank because they want to hold sleek and shiny central bank digital currency instead. (Presumably they didn't desert their banks when banknotes were around because cash was bulky and couldn't be transferred instantaneously over a communications network.) By causing a mass draining of deposits—i.e. disintermediating commercial banks—a new digital currency would impair the ability of banks to make loans, and this would affect the economy in a negative way.

To show why I don't think the Carney critique holds, we need to investigate one of the important differences between cash/digital currency and bank deposits. When people open bank accounts, what interests them is not just the idea of making payments with those accounts but also maintaining a relationship with the bank in order to benefit from a smorgasbord of other financial services. People with bank accounts are like subscribers to a magazine, they want an ongoing connection.

Those who use cash, on the other hand, would rather just buy the magazine once rather than subscribe to it, or—for another analogy—prefer using disposable plastic plates to maintaining a set of their own plates. Cash is a one-time use commodity; once you spend it, any relationship to its issuer is severed. This lack of an ongoing connection provides value to some people. Consider the process of budgeting. By sticking some cash in an envelope dedicated to groceries, another for rent, presents, entertainment, clothing, you can closely monitor your spending over the course of a month. Once the cash is used up, spending stops. With a bank, however, a connection remains even after someone's balance has fallen to zero, spending potentially continuing via overdrafts and credit cards. People who may not trust themselves to stay within their means may therefore prefer the one-time use nature of cash.

So when digital currency replaces cash, I don't anticipate a mass migration from bank accounts to digital currency. Depositors who have already chosen a subscription-based banking solution over a one-time payments solution won't change their minds when the next generation one-time use product is introduced. Which isn't to say that there won't be some sort of migration out of bank deposits and into a new digital currency. Consider upstanding members of society who have always wanted to make anonymous digital payments but haven't had the chance to do so because the only anonymous option theretofore available to them—cash—was a physical medium, and so instead they have opted for the inferior option of non-anonymous digital payments services of a bank. This group of anonymity seekers will make the switch.

But the migration of legitimate anonymity seekers out of bank deposits into digital currency will be counterbalanced by a reverse migration out of cash into bank deposits. Let's think for a moment about who uses cash. Illicit users like criminals and tax evaders are big users, and when cash is demonetized they will all shift into digital currency in order to preserve their anonymity. Likewise, licit users of cash who want to keep using a one-time use payments option will opt for digital currency. The undocumented and those who are too poor to qualify bank accounts will also make the migration into censorship resistant digital cash.

That leaves one major group of cash users unaccounted for: those who use cash not because they like any specific feature that it provides but out of pure force of habit. With cash being cancelled, habitual users will have no choice but to switch into some other payments option. And since deposits are the time-tested option, it is likely that many will move their funds into the banking sector. If this wave of inbound habitual users is greater than the wave of outbound anonymity seekers, then the introduction of a digital currency may actually be lead to an increase in bank intermediation rather than Carney's disintermediation!

-----

So if a digital currency won't affect the banking system during regular times, what about Carney's times of stress criticism? The general criticism here is that during a crisis, households and businesses will desperately shift their deposits into the ultimate risk-free asset: central bank money. Presumably when deposits were only redeemable in banknotes (as is currently the case) and one had to trudge to an ATM to get them, this afforded people time for sober contemplation, thus rendering runs less damaging. But if small depositors can withdraw money from their accounts while in their pajamas, this makes banks more susceptible to sudden shifts in sentiment, goes the Carney critique.

I don't buy it. Small depositors won't exit banks during a crisis because their money is insured up to $250,000 (in the US). But even in jurisdictions without deposit insurance, I still don't think that shifts into digital currency in times of stress would exceed shifts into banknotes. A bank will quickly run out of banknotes during a panic as it meets client redemption requests, and will have to make arrangements with the central bank to get more cash. Thanks to the logistics of shipping cash, refilling the ATMs and tellers will take time. In the meantime a highly visible lineup will grow in front of the bank, exacerbating the original panic. Now imagine a world with digital currency. In the event of a panic, customer redemption requests will be instantaneously granted by the bank facing the run. But that same speed also works in favor of the bank, since a request to the central bank for a top-up of digital currency could be filled in just a few seconds. Since all depositors gets what they want when they want, no lineups are created. And so the viral nature of the panic is reduced.

But what about large depositors like corporations and the rich who maintain deposits well in excess of deposit insurance ceilings? During a crisis, won't these sophisticated actors be more likely to pull uninsured funds from a bank, which have a small possibility of failure, and put them into risk-free central bank digital currency?

I disagree. In a traditional economy where banknotes circulate, CFOs and the rich don't generally flee into paper money during a crisis, but into short-term t-bills. Paper money and t-bills are government-issued and thus have the same risk profile, t-bills having the advantage of paying positive interest whereas banknotes are barren. The rush out of deposits into t-bills is a digital one, since it only requires a few clicks of the button to effect. Likewise, in an economy where digital currency circulates, CFOs are unlikely to convert deposits into barren digital currency during stress, but will shift into t-bills. The upshot is that banks are not more susceptible to large deposit shifts thanks to the introduction of digital currency—they always were susceptible to digital bank runs thanks to the presence of short-term government debt.

The ability to mitigate shifts out of the banking system during times of stress may be even more potent in a world with digital currency than one without. During a crisis a central bank will generally reduce its main policy interest rate in order to stimulate the economy, short-term market interest rates falling in sympathy. Now, consider an economy with banknotes. Even as short-term rates fall, the interest rate on banknotes stays constant at 0%, the effect being that the relative return on banknotes steadily improves. This only encourages further shifts out of the banking system into cash.

Digital currency updates the cash model by introducing a wonderful new invention: the ability to adjust the interest rate on cash. Now when the central bank reduces its policy rate to offset the weakening economy, it can simultaneously reduce the rate on digital currency. This has the effect of maintaining a constant relative return on currency throughout the crisis. So unlike a banknotes-only world in which the relative return on notes steadily improves as the crisis deepens, thus encouraging disintermediation of the banking sector, a digital currency-only world guards against the sort of return differential that might engender disintermediation.

-----

So the Carney critique, which frets over mass adoption of digital currency, doesn't amount to much, in my view. A better critique of digital currency is the exact opposite: instead of mass adoption, it is very possible that no one (apart from criminals and tax evaders) uses the stuff.

Let's see why digital currency could fail on takeoff. One potential migration pattern I mentioned above involves upstanding members of society who desire anonymous online payments adopting digital currency. But what if there just aren't that many people who care about online privacy? Countries like Sweden, where banknote usage is plummeting, give credence to this concern while surveys of cash users in the eurozone show that anonymity is not terribly important to them:

Europeans prefer cash not because of its anonymity or immediate settlement, but because it provides a "clear overview of expenses". pic.twitter.com/JUjSB6aDZ6

Another large base of potential digital currency users includes all those who value cash for both its throw-away nature and lack of censorship. But what if these people choose to adopt pre-paid debit or credit cards instead, both of which are open systems that do not obligate users to maintain an ongoing relationship with the issuer?

If neither of these blocks of licit users adopts digital currency, that leaves only criminals and tax evaders keen to use a new central bank digital currency. For a central banker who is advocating the stuff, that's not a very firm political leg to stand on. In sum, Carney has got it all wrong. A central bank digital currency is less likely to have a massively disruptive effect than it is to arrive stillborn.

PS: Thanks to Antti, Oliver and the rest on the discussion board for helping me think about this more concretely.

Wednesday, April 11, 2018

Courtesy of Kerry Taylor's twitter feed, here is a chart which was presented during a recent investing conference in Toronto. Apparently bitcoin has a moneyness score of 22 while cowry shells ring the bell at 15, both of them exceeding the moneyness of U.S. dollars at 13. The presentation that contains the chart was created by angel investor Sean Walsh and is available here.

Since my blog is called moneyness, and I've written quitea loton thistopic, I feel somewhat obligated to chime in. Let's start with the good bits about the chart. Instead of classifying items as money-or-not, we can appraise objects by their degree of moneyness. Because every valuable object or instrument is exchangeable, some more easily than others, everything lies somewhere on the money spectrum. The diagram below illustrates this idea. This way of looking at things can provide some insights that we don't normally get when taking the money-or-not approach, and its nice to see that folks like Walsh are using it. (For a longer explanation of moneyness, go here).

Now the not-so-good bits. Let's go and see what Walsh means by the term moneyness. On page 14 he lists six characteristics of money including scarcity, durability, divisibility, recognizability, fungibility, and tranportability. Walsh compiles an instrument's moneyness score by assigning a value from 0-4 for each characteristic and then summing this up. The maximum score is 24, with bitcoin losing just a point on durability and fungibility. He gives no explanation for how or why some instrument might get a 3 for, say, recognizability instead of a 4, so I guess we'll just have to assume he has a consistent method for rewarding points.

There are two reasons why I disagree with this approach. First, even if we accept Walsh's definition of moneyness and his choice of rankings for each instrument, his list of attributes is incomplete. It is missing one of the most important ones: price stability. When people accumulate balances in anticipation of spending needs, they expect those balances to hold their value for a few days, maybe weeks. If the medium's purchasing power is volatile, then there is a risk that the stuff in their wallets won't allow them to meet tomorrow's spending requirements, which means it isn't doing a very good job as a medium of exchange. Bitcoin probably has the lowest stability of the instruments in the chart.

My second and more important criticism has to do with the way that Walsh measures moneyness. In a hard science like chemistry or geology, ranking each objects' physical characteristics might pass muster. For instance, geologists use the Mohs Hardness Test, a scale from 1-10 for testing the resistance of a mineral to being scratched. Walsh is running something like the Mohs Hardness Test, except for monetary instruments.

But economics involves humans. And in economics, we are not interested in the physical characteristics of the goods and services people buy, say how hard a mineral is, or how cushy a couch is, or how fast a car can go. Rather, we are interested in the subjective evaluation economic actors place on those objects and the manifestation of these preferences in the form of market prices.

So the way to accurately measure moneyness isn't to design the equivalent of Mohs Hardness Test for monetary instruments, but rather to find out what price people actually put on that moneyness. One way to do this is by asking how much compensation people would expect to earn if they were to give up an object's moneyness for a period of time. More specifically, say you are offered a deal to buy one bitcoin but are prohibited from selling that bitcoin for one year. How much less would you be willing to pay for this locked-in bitcoin than a regular bitcoin that you will probably hold for at least one year anyways? If a locked-in bitcoin is worth, say, $500 less to you than a regular bitcoin, that means that you place $500 on a regular bitcoin's one-year tradeability, or its moneyness.

We can also think about moneyness in terms of interest rates. What rate would you need to earn on a locked-in bitcoin to compensate you for the nuisance of giving up its ability to be used as an exchange medium? 10%? 5%? The extra interest you expect on locked-in bitcoin is the degree to which you value a regular bitcoin's tradeability, or moneyness, over that time-frame.

The price of a dollar's moneyness is easy to measure. Someone who will have a spare $10,000 on hand for the next year can hold it in a government-insured chequing account and earn 0% or they can lock that amount into an insured term deposit and earn around 0.85% (I'm using Canadian numbers for non-cashable 1-year GICs). By locking in the $10,000, an individual's ability to mobilize these dollars as a medium for making payments has been effectively destroyed for 365 days. They cannot buy stocks or bonds with it, nor convert it into cash, nor purchase peaches, tables, labour, travel, etc. Their dollar are inflexible; they have no moneyness.

People are willing to accept this burden but only if they are compensated to the tune of 0.85%. Put differently, the 0.85% rate represents a large enough carrot that marginal depositors are roughly indifferent between holding money in a chequing account for a year or locking it in. So if $10,000 in a term deposit provides a pecuniary return of $85, then $10,000 dollars held in a 0%-yielding chequing account provides around $85 in non-pecuniary monetary services, or moneyness, over the course of the year.

We can also go through this process with gold. Head over to Kitco and you can see that the 12-month lease rate is at 0.2%. Say you are hoarding $10,000 in gold under your mattress. If you are willing to forfeit the ability to make any transactions with your $10,000 stash for one year, a bank will compensate you with $20 ($10,000 x 0.2%) for your pains. Put differently, $20 is the amount that the bank needs to provide the marginal gold hoarder to tempt them into giving up the moneyness of gold. (The implied moneyness of $20 is far less than the $85 a Canadian chequing account offers, contrary to Walsh's chart, which ranks gold above dollars. Note that I am ignoring storage costs.)

To carry out this measurement for bitcoin, we'd have to determine what sort of rates a large international bank provides to bitcoin term depositors. I doubt this measurement can be made since reputable banks don't deal in bitcoins. So bitcoin's moneyness is not 22. We have no real idea what it is.